By Martin Small, Head of US iShares at BlackRock

As the recent market volatility made clear, there’s a big difference between plain vanilla ETFs and leveraged products making big bets with big risks.

Martin Small, head of US iShares at BlackRock.

I love movies that pivot on mistaken identity.  From Desperately Seeking Susan(Madonna) to The Big Lebowski (Jeff Bridges), I get hooked when one character is falsely assumed to be another. But, mistaken identities should be reserved for the movies, not the exchange-traded products (ETP) market.

Over 97% of the $5 trillion global ETP market consists of exchange-traded funds (ETFs): the plain vanilla, traditional, open-end index funds that can be bought and sold like a stock. (Source: BlackRock Global Business Intelligence.) Most ETFs are designed to do what they say on the tin: help investors target returns of stocks and bonds. Indeed, the lion’s share of ETF assets are in major, broad-based market indexes that are the building blocks of global asset allocation. ETFs are intuitive and well understood.

There is also a small subset of ETPs that use financial engineering in an effort to magnify returns on different markets. These niche products are worth roughly $80 billion in assets, or a paltry 1.5% of the overall ETP market, according to BlackRock GBI.

Unfortunately, these products are often mistaken for plain vanilla ETFs. Here’s why it’s a problem. The financial engineering employed in these products includes the use of borrowed money (leverage) to magnify returns, as well as derivatives like options that stand to gain or lose money based on fluctuations in market prices.

For example, inverse ETPs seek to deliver the opposite performance of the indexes they track. And leveraged inverse ETPs seek to deliver a multiple, say two or three times, of that opposite. Many of these products have complicated provisions that trigger early liquidations when there are large price declines and periodic resets of leverage factors, which means the performance of “geared” ETPs can be very different than that of traditional ETFs.

Our experience is that these complex provisions are not intuitive or well-understood by many users of the products. Indeed, prospectus disclosures for geared ETPs generally state that they may not be suitable if you seek an investment with a longer duration than a daily basis.

Traditional ETFs have been repeatedly battle-tested in stressed markets, including the large four-to-eight percentage-point selloffs we saw on February 5.  US equities traded an impressive $622 billion that day, ultimately logging the single-largest ever point fall on the Dow Jones Industrial Average. It also witnessed the largest percentage gain ever on the Cboe Volatility Index (VIX Index), a key measure of market expectations for near-term volatility. (Source for equities and VIX: Bloomberg.)

On February 5, traditional ETFs posted a healthy $240 billion of trading volume globally, according to Bloomberg; they helped markets efficiently move capital and investors to implement their different views, across asset classes and countries. Consider that only nine stocks in the Russell 3000 Index traded in a price range greater than 15%, reflecting an orderly, well-bid two-way market. (Source: Virtu Financial)* Frankly, I marvel at the efficiency.

Leveraged and inverse VIX-tracking ETPs did not fare as well on February 5. These products are generally constructed to take big bets, through borrowed money and derivatives, on changes in the VIX Index or VIX Index futures. (VIX levels are determined by changes in supply and demand in the S&P 500 Stock Index options market.)

With the rapid volatility spike on February 5, VIX-tracking ETPs did what they were built to do: They experienced large-scale price changes (Bloomberg), which in some cases resulted in trading halts and in others accelerated redemption events. To be clear, VIX ETPs did not cause the price changes; they just mirrored the buying and selling of options and futures on U.S. equities.

But make no mistake: These should not be confused with ETFs.

BlackRock has long supported a classification and naming system for ETPs.  We believe products that use financial engineering should be labelled as “exchange-traded instruments” (ETI). Stakeholders should also consider enhanced suitability standards, permissions and disclosures for the trading of ETIs, similar to practices in options markets.

Let’s leave mistaken identity to the world of fantasy and fiction, and be crystal clear about who’s who when it comes to ETPs.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)